Reference no: EM132571149

Trimming the Fat to Boost Profitability

• To reduce production costs, Automaton's COO, Christine Brady, suggests replacing one of its manufacturing equipment with a newer, more efficient model. This four-year project will result in reduced manufacturing costs which, in turn, would allow Automation to reduce the price of its flagship AI CalcPro IV. Christine believes reducing the cost of the processor will better position Automation to compete with AI-CHIP.

• The current equipment, a MAC-98, can be sold today for $1,000,000 net. A brand-new MAC-100 retails for almost $3,250,000; however, Christine believes she can purchase it for $3,000,000 today. She will fund this purchase in part with proceeds from the sale of the MAC-98. In addition, accounts payable are expected to increase by $1,500,000 today, and fully reverse in year 4.

• The new equipment will be in operation beginning in year two. As the old equipment will be offline in year 1, Christine forecasts lost revenues of $550,000 in year 1 arising from the idled equipment. The cost savings in years 2, 3 and 4 are estimated at $600,000, $950,000, and $1,000,000, respectively. Automaton's cost of capital and tax-rate remain unchanged. The equipment is depreciated using straight line depreciation (i.e., Equipment Cost - Salvage Value) / Useful Life). Christine assumes the equipment will be worth $5.00 after four years.

• Kofi is particularly excited about this project and goes about evaluating it. He is a bit unclear about how changes in depreciation impact FCF, and seeks guidance from Christine. Christine makes the following two statements: "All else equal, higher depreciation expenses will result in larger FCF and lower net income. Also, the specific impact of changes in depreciation expenses on FCF can be discerned by multiplying the incremental depreciation expense by the tax rate."

Questions

Question 1. What is the initial cash outlay for this project (i.e., year 0 cash flows)?

Question 2. What is this project's FCF for years 1 through 4?

Question 3. What is this project's NPV and IRR?

Question 4. Kofi (again) is concerned that the estimated cost of capital for Automaton is too high. He adjusts Automaton's Beta and computes a new cost of capital of 5 percent. Using this, what is this project's NPV?

Question 5. Is Christine's comment on the relationship between depreciation and FCF and depreciation and net income accurate? Discuss briefly.

Question 6. Is Christine's second comment accurate? Discuss briefly.